Structural Break
Natural gas has historically hovered in a price range defined by oil prices. The reason historically comes from the fact that part of natural gas production is a byproduct of oil extraction (found in same wells). In addition, industry and power generation have long been able to switch back and forth between natural gas and residual fuel oil. The conventional and expected market price bracket of natural gas prices used to be thought as the following:
Upper band: The heat content (million BTU per barrel) of distillate fuel oil is 5.825. Hence, the upper limit for natural gas price should be a sixth of the current price of a barrel of oil.
Lower band: based on past observation, natural gas prices should mean revert around a ratio of 10:1.
There seems to have been a structural break here as the chart above shows. Since the outburst of the crisis, nat gas prices are pegged well below the lower band.
Power generators able to switch easily from nat gas to residual fuel have dwindled in numbers. This may explain the reason for a new equilibrium between oil and nat gas.
Finding the Missing Link
Even though the nat gas market is competitive and well integrated nationally it remains mostly local in comparison to oil prices. The recent widening of the WTI/Brent spread has highlighted the extent to which U.S. oil prices may depend on domestic supply conditions (overload at Cushing, OK). But oil prices remain strongly affected by international factors such as global demand, OPEC policy, and geopolitical risk.
Supply Side: The Shale “Revolution”
Reserves have also played an important role recently due to the shale gas “revolution." This new source of gas has benefited from extracting innovation (horizontal drilling/hydraulic fracturing) that lower production costs. It represents only 15% of U.S. supply (approx 9 bcf/d out of a total U.S. production of 58.5 bcf/d) but accounts for most of the marginal increase in dry gas production.
In addition, according to the Potential Gas Committee, the United States possesses a total resource base of 1,898 trillion cubic feet (Tcf) as of year-end 2010. This is the highest resource evaluation in the Committee’s 46-year history, exceeding the previous record-high assessment by 61 Tcf. Most of the increase arose from reevaluation of shale-gas plays in the Gulf Coast, Mid-Continent and Rocky Mountain area. According to EIA, U.S. total nat gas reserves are estimated at 2550 Tcf (more than one century of supply) from which Shale gases account for 830 Tcf (Marcellus, Haynesville, Barnett and Fayetteville basins account for 600 Tcf). The U.S. economy is becoming self sufficient in terms of nat gas supply. Yet, one should always keep in mind that potential/technically recoverable resources are not the equivalent of proved reserves.
This leaves the U.S. economy with a huge amount of supply for the foreseeable future and a genuine cap on prices if demand fails to catch up (primary energy substitution takes time as oil to coal substitution showed in the 19th and 20th century).
There might be some over optimism on the supply potential. Regulatory requirements could emerge shortly (burning natural gas is environmental friendly but the extraction of shale gas not really: land access may be constrained; water access/use and contamination is a key issue; health impacts are unknown). The rapid depletion of newly discovered fields could also be a cause for concern.
From Oil to Coal: Power Generation and Coal-to-Gas Switching
The demand potential for natural gas is high: Residential heating, car/truck conversion. Yet, without coal-to-gas switching, natural gas prices would be much lower today. The over supply of natural gas has enabled a sharp reduction of imports, but in the absence of LNG exports facilities, part of the excess supply has been dedicated to power generation ... at the expense of coal.
According to EIA data, from 2000 to 2009, the share from coal in power generation fell 7.2% from 51.7% to 44.5% while that of natural gas rose 7.5% from 15.8 to 23.3%.
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